Surviving the Foreclosure Crisis

By Paul D. Pearlstein

Illustration by Michael Austin/gettyimages.com

Background

Grim statistics reveal that as many as 10,000 foreclosures are occuring each day in the United States—and the total is climbing. All this while a financial meltdown roars around the world. Unemployment is high, inflation is increasing, and real estate values are plunging, as is the stock market. Yes, we live in interesting times.

Most of the problems began years ago when banks and savings and loan associations started selling their mortgage loans—rather than holding them—to replenish funds to make more loans. This became the norm in the banking industry, such that today almost no bank continues to hold and collect payments on the loans it makes. This allowed the lender to process many more loans. Unfortunately, it also compromised the underwriting of loans since the loans often were merely hot potatoes quickly sold to others for ownership and servicing.

And then it got worse. In the 1980s lenders began to pool mortgages and securitize them for sale on Wall Street. The quality of individual loans seemingly was irrelevant since most conventional mortgage security pools were backed by Fannie Mae and Freddie Mac. Because the loans were being sold as a security, small increments of the total loan pool or package could be sold on the national and international stock markets.

As these investments became more and more popular, the secondary mortgage market went on steroids. It began selling mortgage derivatives and futures, and sold pieces of the mortgage pools such as years 1 through 5 or years 21 to 30, much like butchers use all of the pig, including the ears and the oink. The lawyering and marketing were most creative, but the control and valuation were impossible. When the mortgage market began to sputter due to the predatory and unsecured loans, foreclosures increased, causing home values to decline. Like an epidemic, confidence in all mortgages came into question and the entire house of cards began to come down, augmenting the number of foreclosures.

Some Basics

A normal home purchase involves: 1) a promissory note (IOU) to the lender for the loan to purchase the house; 2) a deed of trust or mortgage securing the promissory note for the lender (if the note is not paid, the house can be sold to repay the lender); and 3) the servicing company that collects the monthly payments on behalf of the lender. This company may be the lender, the entity that purchases the loan from the original lender, or a separate entity contracted to do the collection work. If the secured notes are pooled or packaged with others, the lender sells and assigns its interest in the secured note and the security to the pool. The servicer then continues the lender’s work until the note is paid or foreclosed upon.

Loans should be made based on the value of the house and the ability of the borrower to repay the loan. In turn, the loans are secured by the collateral property. In the event of a default, the home may be sold (foreclosed), the lender paid off, and the borrower repaid if there is any excess. In a push to sell more homes and originate more loans, many loans in recent years were made to people without the capability to pay and whose properties’ values were not sufficient to repay the loans. If there was a foreclosure, this resulted only in a partial repayment of the loan, leaving a deficiency judgment against the borrower and an increased supply of real estate for sale. As foreclosures increased, even more real estate came on the market, pushing down the value of all real estate due to excess supply. The combination of a faltering economy, poor job market, and tightening credit market prevented buyers from getting new loans to refinance, buying a new home, or selling their homes to protect what little equity might exist.

Foreclosure Process

The basic foreclosure process involves notice to the property owner/borrower, advertisement of the foreclosure sale, and public sale of the property, usually at an auction house or at the courthouse. Often there is a right of redemption prior to the sale, but once the gavel falls on the auction, there usually are no rights of redemption. This simplistic, nonjudicial scheme is in effect in the District of Columbia and Virginia for both residential and commercial foreclosures. In Virginia, there is an accounting review by the Commissioner of Accounts before distribution is finalized, but this is not a judicial review or approval process.[1] In both the District of Columbia and Virginia, nonjudicial foreclosures can be completed within a short period of time, often 60 days or fewer.

Maryland commercial foreclosures follow the basic format described above,[2] but with a judicial confirmation of the sale and distribution. However, Maryland residential foreclosures are directed by new legislation that came into effect April 4, 2008.[3] This legislation provides for attempted personal service on the record owner before any alternative service may be allowed, and requires a minimum of 45 days to schedule an auction after service has been accomplished, or no fewer than 90 days after the initial default.

A complaint to foreclose must be filed with and acted upon by the court before the sale can go forward. The right of redemption remains available up to one day prior to the auction. Thus, a minimum 90-day delay is expected before a residential foreclosure in Maryland can be completed.

There are federal laws that interact with and may affect state foreclosure procedures such as those involving Federal Housing Administration (FHA) and Veterans Affairs loans. Some of these laws, as discussed in the succeeding paragraphs, may provide defenses to the foreclosure. If the United States has a lien, it will have the power to redeem any property sold for a period of one year or for 120 days if it is an Internal Revenue Service lien.[4] Such federal right of redemption may be waived or quashed, but the buyer must be careful to take proper action, preferably before the sale.

What to Do?

Despite the gravity of a foreclosure situation, much of the required counseling is embarrassingly simplistic and frequently ignored.

  1. Advise Your Client to Open and Read All Mail. It is not uncommon for people in debt to completely repress the situation by not opening any mail that resembles a bill or collection notice. Such behavior can go on for months until well after their home has been sold. The homeowner may then claim, correctly but incredulously, “I was never notified.”
  2. Advise Your Client Not to Hide From the Creditor. If the client is in arrears on his or her note, contact the lender or have the client do so, preferably in writing. Get the names and numbers of anyone who has been contacted about the problem and explain what is happening in the client’s life that is causing the problem. There is seldom any quarter given to a debtor who cannot be reached.
  3. Homeowners Must Not Promise Anything They Cannot Deliver. Once a homeowner in default breaches a future promise to perform, his or her credibility is completely gone and the homeowner comes under the mercy of the creditor.
  4. Get Help. Encourage the client to find a friend, family member, or professional (clergy, lawyer, or psychiatrist) with whom to discuss the problem. There are federal, state, and local mortgage counselors who should be contacted. Their advice may or may not provide a solution, but stating the problem out loud is the first step to dealing with it.
  5. Try to Work Out New Terms That the Client Can Handle With the Lender/Creditor. Surprisingly, this is easier done with huge, multimillion-dollar commercial debt than with smaller residential property debt. Still, it is worth a try. The U.S. Department of Housing and Urban Development and several lenders are now offering individual workout plans if the basic income is there. The objective is to establish absolute credibility with the creditor and propose something that is realistic, even if it is much less than the creditor wants. The debtor’s strength is that a lender wants a performing loan, not real estate.
  6. Investigate All Private Resources, Including Personal Banks, Employers, Relatives, and Friends. The debtor must expect to deal with everyone (especially friends and family) on a professional, arms-length basis by offering written contracts, notes, and security where possible. Don’t expect favors.
  7. Public Assistance. Many states have some public resources available for short-term assistance and possibly longer.
  8. Refinance. If there is any equity in the house and an income stream, it may be possible to negotiate a new secured debt. New terms may be available that would allow a homeowner to pay off the arrearage, stop the foreclosure, and acquire more realistic terms for the future. FHA Secure and Hope for Homeowners are new federal programs to examine.
  9. Investigate a Reverse Mortgage. If there is equity in the property and if the owners are at least 62 years old, they may be able to qualify for a reverse mortgage. This could provide a substantial sum of money to live on or pay off or fund the debt service to the secured creditor and stop the foreclosure process. With luck, there could even be something left for the owner’s heirs if the property appreciates sufficiently and if the reverse mortgage terms allow for such.
  10. List the House for Sale. Cooperate with the foreclosing creditor to delay the foreclosure to provide reasonable opportunity to complete a sale. The lender wants its money, not another house to sell. Many lenders are willing to allow an attempted sale as long as they can trust the seller or monitor the effort. The lender must be comfortable that the seller is using his or her best efforts and showing good faith to sell the house quickly.
  11. Ask for a “Short Sale.” A short sale is a sale permitted by a lender in which the proceeds are not sufficient to pay off the secured debt. The lender will release its secured lien to liquidate a nonperforming loan, get some immediate cash, and offload the residence without having to own or sell it itself. The problem is with the remaining debt on the note (IOU) which could result in an unsecured deficiency judgment against the selling borrower. Some states prohibit deficiency judgments after a foreclosure, but that is not true for the District of Columbia, Maryland, or Virginia. However, some lenders will waive the judgment as a term of negotiation to make the sale and minimize their loss.
  12. Deed in Lieu. It may be possible to avoid a foreclosure by voluntarily turning the property over to the lender/creditor. This saves a good deal of expense for the creditor and may give it control over the property to obtain a better sales price to cover all of the secured debt if there is a large equity position. The problem is that the lender will own the property and must insure and maintain it until it is sold. If there is a reasonable chance that someone will buy the house at a foreclosure auction and pay them off, lenders will not likely agree. If a deed in lieu is possible, the owner should try to get the creditor to agree not to obtain a deficiency judgment in the event the proceeds of the sale is less than the full payoff for the secured note.
  13. If the Problem Cannot Be Solved, Inform the Client That He or She May Wish to Move Out and Move on. The stress of a pending foreclosure can be devastating, and many people cannot deal with it. Severe depression and even suicide may occur. If the burden is too great, let the house go and move on with life.

What Not To Do?

Avoid panic and knee-jerk reactions to a threatened foreclosure. Be extremely cautious and carefully review and analyze any proposal that is offered in a crisis mode. If the offer seems too good to be true, it almost always is.

Rescue operations, predatory loans, and other scams take many forms. One involves the purchase of your home for the amount of the arrearage, with the buyer’s promise to pay the mortgage and to rent the house back to you with an option to buy. This process fails in many ways. The repurchase price is usually too high to be accomplished by the distressed owner. The rent is high and the lender may soon be able to evict the tenant/prior owner and sell the property for personal gain. The purchaser may refinance the residence, pocket the funds, and not pay the debt service, thereby allowing a foreclosure. Also, the original lender may accelerate the loan due to the transfer of ownership in the rescue without its permission (i.e., the due on sale clause in the mortgage).

A rescuer may offer to refinance the home, promising a lower monthly payment that is usually a low tickler rate with an adjustable rate mortgage. This usually involves a high origination fee, providing immediate profit for the lender. Then there is the higher interest rate that often kicks in after only a few months. Finally, as the loan goes into arrears, the rescuer may foreclose, flip the property, and take any equity in the sale as additional profit. This is a typical scenario for a subprime, predatory loan where the owner has poor credit.

There are many variations to this scheme. Beware of anyone calling or making direct solicitation, especially when that person comes with a copy of the published foreclosure notice or the salutation, “I can save your home from foreclosure.” Another clear sign of trouble is when the lender’s representatives do not ask about the borrower’s assets and liabilities, or make any attempt to authenticate the numbers the borrower or the representatives put down on paper.

Do not exhaust retirement funds or savings. If this is the only method left of sustaining a monthly mortgage payment, it is probably best to give up the house through sale or foreclosure.

Do not use credit cards to pay the mortgage. The easy availability of a credit card line often induces people to start kiting with multiple credit cards, staying one payment ahead until all credit lines are exhausted. Use of a credit card to pay a mortgage is a sure sign that the client has severe financial problems, and certainly cannot afford to pay the 17 to 32 percent-plus interest rates of credit cards.

Defenses

Until October 17, 2005, the bankruptcy system helped individuals, companies, and the economy in general absorb most economic downswings and provided relief for many foreclosure problems. Chapters 11 and 13 of the Bankruptcy Code allowed a restructuring of the arrearage and gave homeowners the chance to refinance the secured loan, renegotiate future debt service with the lender, or provide orderly liquidation to save the equity in the home. Unfortunately, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 greatly reduced the possibility of help and a fresh start, thanks to the credit card and banking lobbyists. This legislative twist has blocked an important avenue for relief and exacerbated the current foreclosure crisis into a full-scale national economic downturn. It seems a waste to not utilize the very forum that has experience dealing with troubled assets and buffering business cycles for almost two centuries.

Currently, bankruptcy courts may not readjust an individual debtor’s secured loans on a residence. It would seem far simpler to allow bankruptcy courts to adjust secured loans on troubled residential mortgages as they continue to do with secured commercial loans. But since bankruptcy courts may not provide their assistance, Congress has authorized a global solution to the foreclosure and credit problems with its $700 billion bailout program for the entire financial industry. Meanwhile, Fannie Mae, Freddie Mac, Federal Deposit Insurance Corporation, FHA, and individual lenders are toying with their own disparate solutions.

Bankruptcy provides an automatic stay of execution with the mere filing of a bankruptcy case.[5] This will immediately stop a foreclosure, but the secured creditors can quickly return to court to try to get relief from the stay and continue the foreclosure.

There are three bankruptcy chapters available to most individuals in this area. Under a Chapter 7 filing, title to the property is vested in the bankrupt estate that is administered by the trustee. The real estate involved can be 1) sold by the trustee for the benefit of the estate creditors, 2) abandoned by the trustee if there is no equity in the property that could benefit the creditors, or 3) allowed to go into foreclosure after a motion by the secured creditor or upon abandonment by the trustee. In such a case, a debtor may have several months left before being forced out of the property, and he or she can receive a discharge of all debts, including any potential deficiency judgment.

A Chapter 13 filing will stop a foreclosure but it, too, can quickly be undone. To continue to be protected by Chapter 13, a debtor must pay his or her full monthly debt service after filing and propose a payment plan for the arrearage that is confirmable by the court. This chapter filing may buy some time, but it usually fails to save the house because the owner is unable to pay the current debt service in addition to the plan payments. But if there is equity in the home, a debtor may be able to avoid the foreclosure and put the house on the market for a sale that would bring more than a forced auction. However, the mere filing of bankruptcy and its automatic stay may provide the debtor an opportunity to negotiate with the secured creditor on a more level field.

While Chapter 13 is limited by the size of the secured and unsecured debts[6] and the length of time a plan must be completed, Chapter 11 has no size or time limits. In light of the extraordinary appreciation of real estate in the Washington metropolitan area, only Chapter 11 may be available for any relief from foreclosure and a reorganization of the debt and payment schedule. Unfortunately, a Chapter 11 filing is a more complex procedure involving larger legal fees. Chapter 11 does authorize the court to reclassify a secured debt into a partially secured and partially unsecured debt when the asset is worth less than the lien, but this treatment is not available for the residence of individual debtors in either a Chapter 11 or Chapter 13 filing.[7]

Filing a lawsuit against the lender that has commenced a foreclosure avoids bankruptcy and brings you before a judicial forum that can either delay or terminate a foreclosure. To stop a pending foreclosure without the bankruptcy automatic stay, a temporary and permanent restraining order is necessary. This can be accomplished by filing a complaint and a motion for temporary restraining order to be heard by the Superior Court of the District of Columbia Judge-in-Chambers, or the designated judge in Maryland and Virginia.

The complaint may include counts for violations of the federal Truth in Lending Act,[8] Regulation Z,[9] Real Estate Settlement Procedures Act,[10] D.C. Consumer Protection Act,[11] D.C. Home Equity Protection Act of 2007,[12] the new Maryland Protection of Homeowners in Foreclosure Act,[13] Consumer Credit Protection Act,[14] and Fair Debt Collection Practices Act,[15] as well as actions for fraud and conspiracy, obviously depending upon the facts. It may even be possible to raise claims on the underlying loan after the statute of limitations has run out, if the claims are raised in defense of a foreclosure. In addition to suing the lender, everyone involved in the loan transaction such as the settlement attorney, the title insurance company, and the loan broker may be a potential defendant. Let Rule 11 be your guide.

As a matter of litigation tactic, it is important to demand that the original documents and records be produced at trial. This includes the promissory note, disclosure statements, all documents involved in the loan and settlement, as well as all records involving payments, posting of payments, and calculation of credits, interest, finance charges, and late fees. Often there are errors. More often, because of the multiple sales of the debt instrument, these records cannot even be located.

Despite the many possible defenses that may exist, any homeowner facing foreclosure should do a cost-benefit analysis. Has the homeowner’s financial condition significantly improved and can he or she afford to attempt a cure through litigation or bankruptcy? Most bankruptcies will not permanently cure a problem, nor will most litigation. Both are expensive procedures and, at most, are only likely to buy time unless there is a strong case of fraud or a serious violation of one of the consumer statutes that could result in treble damages, attorney’s fees, and punitive damages. One test of the probability of success is to see if there is any experienced attorney who will take the case on a contingency basis. Such representation is unlikely unless there is a very high probability of monetary recovery, apart from any renegotiation of the mortgage terms.

Several area organizations also provide free or reduced-fee advice or even representation to fight or survive a foreclosure.[16]

Survival: Before and After

Upon receiving several default and demand letters or an actual foreclosure notice, it may be helpful for the client to at least consider the possibility of life without his or her home. Planning for a possible move to cheaper housing is unpleasant, but it is better than dealing with the aftermath of a probable eviction.

Recognize that there is still a process and the foreclosed party continues to have rights even after the sale. The foreclosure process will consume time since neither the District nor Maryland or Virginia allows residential evictions without court process. So if you are confident that you cannot afford to keep the house from foreclosure and can handle the angst, you might consider preparing to move but doing nothing more. By not paying any debt service, taxes, rent, or anything else during the inter regnum period before you are ready to leave or when the sheriff or marshal is at the door to enforce the eviction, you may be able to build up a small war chest to assist the transition.

After a foreclosure, and assuming the prior owner has a decent income stream, the debtor should be advised to work on reestablishing credit. Writing a letter explaining why the foreclosure happened can be helpful. Usually a foreclosure is the result of some cataclysmic event such as the loss of a job, a serious injury, divorce, family crisis, fraud, or predatory lending. An articulate and honest explanation will do no harm and may be helpful if sent to the lender and the credit reporting companies.[17]

Finally, have the client reestablish credit by taking out small loans from any institutional lender or making credit purchases from a national merchant—and repaying the debts shortly after they are made. Doing this over a period of several months will establish some positive information in the client’s file with credit reporting companies and institutions with which he or she is dealing. However, avoid secured credit cards whenever possible to reestablish credit.

Credit counseling is mandatory before filing for all individual bankruptcies. Such counseling can be helpful and should also be recommended—if not required—before a foreclosure is started. There also are affinity groups with monthly meetings for people who realize that they cannot control their spending habits. Mental health practitioners may work even better, but at a price.

Notes

[1] D.C. Code § 42-815 and Va. Code Ann. §§ 55-59. et seq. N.B. Va. Code Ann § 55-59.1:1 is a new law that provides special notice, time, and treatment before note acceleration and foreclosure of certain “high risk” loans. However, the new legislation is only temporary and expires July 1, 2010.
[2] Rule 14-204 and Real Property Article, Title 7-105.
[3] MD Real Property Article, Title 7-105 to 105.8.
[4] 28 U.S.C. § 2410.
[5] 11 U.S.C. § 362.
[6] 11 U.S.C. § 109 is indexed yearly. For 2008 it allows $336,900 for unsecured debts and $1,010,650 for secured debts.
[7] 11U.S.C. § 1123(b)(5) and 1322(b)(2).
[8] 15 U.S.C. 1601, et seq.
[9] 46 Fed. Reg. 20892, Apr. 7, 1981.
[10] 12 U.S.C. § 2601-2617.
[11] D.C. Code § 28-3901.
[12] D.C. Code § 26-1171.
[13] MD Real Property Article, § 7-325, Effective Apr. 3, 2008.
[14] 15 U.S.C. § 1601 et seq.
[15] 15 U.S.C. § 1692, et seq.
[16] U.S. Department of Housing and Urban Development-approved housing counselors: AARP Legal Counsel for the Elderly; Archdiocesan Legal Network of Catholic Charities of Washington; Bread for the City; Civil Justice, Inc. in Baltimore; D.C. Bar Advice and Referral Clinic; Federal Emergency Management Administration; Legal Aid Society of the District of Columbia; Manna, Inc.; Marshall Heights Community Development Organization, Inc.; Maryland Foreclosure Prevention Pro Bono Project; Maryland Hope Hotline, 877-462-7555; Maryland Legal Aid Bureau; Neighborhood Legal Services Program, Salvation Army; University Legal Services for the District of Columbia, and Veterans Affairs. Additionally, some of the law school legal clinics may offer help, and D.C. Law Students in Court can help with eviction defenses and rights after a foreclosure.
[17] Equifax: www.equifax.com; Experian: www.experian.com; Trans Union: www.transunion.com.

Paul D. Pearlstein is a certified business bankruptcy specialist whose practice focuses on bankruptcy, real property, and estate planning and probate. http://pearlstein-law.com